Business Quality · Stocks Explained
Turn a claim into evidence
A strong brand, a network, switching costs or a cost advantage may protect profits. None is proven by a confident presentation. Look for evidence such as customer retention during price increases, stable costs relative to competitors or repeat purchases without rising acquisition spending.
Ask what a well funded competitor would need to reproduce the offering. Then identify what could weaken that barrier, including a substitute product, regulation, changing distribution or a new manufacturing process.
Measure the capital required
Return on invested capital, or ROIC, compares operating profit after tax with capital committed to operations. A practical analysis must state how it treats cash, goodwill, leases and research spending. Different definitions can produce different results.
Suppose adjusted operating profit after tax is $18 million and average operating capital is $120 million. ROIC is 15%. If a reasonable estimate of the cost of capital is 9%, the six percentage point spread suggests value creation under those assumptions. Neither input is perfectly observable.
Study incremental returns
Historical returns describe an existing asset base. New investment can earn much less. A business spending $20 million on expansion that eventually adds $2 million of annual operating profit after tax has a simplified incremental return of 10%.
Allow for construction time and ramp up. Do not divide this year’s profit change by this year’s spending without considering timing, acquisitions and the business cycle. Cash flow scenarios can be more informative than one ratio.
Protect the comparison from accounting noise
Internally developed brands or research can be expensed while purchased assets appear on a balance sheet. An asset light business may therefore show very high accounting returns. That is a prompt to investigate, not an automatic ranking.
Compare companies with similar accounting and business models, examine several years and include the price paid for the shares. An excellent business can still be a poor investment if the purchase price assumes unrealistic durability.
Try it yourself
A company earns $12 million of operating profit after tax on average invested capital of $100 million. The assumed capital cost is 10%. What does the comparison show?
Show the worked answer
ROIC is 12%, giving a two percentage point spread over the assumed capital cost. It is evidence to investigate, not proof that all future investment earns 12% or that the shares are attractively priced.
Further reading
Educational material. Examples are hypothetical and do not recommend a security or a personal allocation.
